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Is It Too Late to Invest in Railroads?

If the economy continues to chug ahead, even at low growth rates, rail traffic will rise, resulting in higher earnings for railroads.

Though most railroad stocks have soared in value since the 2008-09 recession, investors can still find opportunities in this space. These companies' earnings are growing thanks to railroads' pricing power, a rebounding economy in North America, a 4% increase in rail-to-truck (or intermodal) shipping this year, and a 35% increase in the shipment of oil and petroleum products.

Union Pacific Corp. (NYSE:UNP), Canadian National Railway(NYSE:CNI) and Kansas City Southern(NYSE:KSU) also saw gains in third quarter activity. Kansas City Southern is the smallest of the three, but owns an excellent North-South franchise with connections to Mexico and Canada. Union Pacific has a diverse western franchise, allowing it to make money in several sectors of the economy. Canadian National Railway is making so much money that it recently announced a share buyback, a 2-for-1 split and fourth-quarter dividend.

The Buffett metricWhen Warren Buffett started buying shares in railroads in the mid-2000s, he felt he was a little late to the game, but he invested anyway.

He previously was reluctant to invest because he knew about railroads' awful performance in the 1970s and '80s when there was a lot of consolidation, poor investment returns and bankruptcies, including the end of the Rock Island Railroad in 1980.

To survive, railroads streamlined their operations and diversified their franchises to create new revenues. By year 2000, the surviving railroads were fairly attractive because their valuations had been beaten down, yet their earnings were improving.

In 2010, Buffett paid $100 per share, or 18 times forward earnings, for BNSF Railway. Based on that metric, Canadian Pacific at a 15.56 forward P/E, Union Pacific at a 14.10 forward P/E, and Norfolk Southern at a 13.55 P/E, look attractive today.

Buffett's 2010 bet paid off immediately: The U.S. Gross Domestic Product grew 2.4% in 2010, 1.8% in 2011 and 2.2% in 2012.

In 2012, BNSF Railway delivered record earnings of $3.37 billion to its parent, Berkshire Hathaway(NYSE:BRK-B), and operating revenues were up 5.39% through the second quarter of 2013.

Railroads are a great barometer of the economy, and 2013 is shaping up to be another positive-yet-slow-growth year for it. U.S. GDP grew 1.1% in the first quarter 2013 and 2.5% in the second quarter. Intermodal volume for the week ended Oct. 19 totaled 264,687 units, up 4.3% compared with the same week last year, and up for the 16th straight week in a row, according to the Association of American Railroads. The increase means there is higher demand for furniture, clothing and manufactured items.

Let's drill down and see which railroad is the best value for the money. We need to look at debt-to-equity ratios, dividend payout ratios and forward P/E.

Name

Yield

Payout Ratio

Debt-to-Equity

Forward P/E

3rd Quarter EPS % growth

Union Pacific

2.10%

32.00%

0.42

14.10

13.24%

Canadian National

1.51%

20.33%

0.52

15.56

9.86%

Kansas City Southern

0.70%

28.10%

0.53

23.89

30.48%

Norfolk Southern

2.36%

34.99%

0.83

13.55

23.38%

Source: Yahoo! Finance and Charles Schwab research.

The railroads featured here all have decent balance sheets; however, Norfolk Southern has the highest debt compared to equity. The company's low P/E multiple is probably due to Norfolk Southern's dependence on coal, which accounted for 23% of its revenues year-to-date, much higher than its peers Union Pacific, Kansas City Southern and Canadian National.

Union Pacific stock recently fell 4% below its 200-day trading average of $155.40. Is there an opportunity here? Union Pacific achieved 13.24% earnings-per-share growth in the third quarter despite losses from flooding in Colorado. If quarterly earnings continue to grow at 13.24% year over year, the company's earnings will double in 5.5 years. Union Pacific has the lowest forward P/E of the bunch at 14.

Kansas City Southern is trading at a much higher multiple at 23.89 forward P/E. However, Kansas City Southern is a smaller railroad able to adapt and change and grow, particularly with trade with Mexico. The company's earnings are growing much more rapidly than its peers, up 30.48% in the third quarter compared to third quarter 2012.

Canadian National's revenues for the latest quarter increased 8% to a quarterly record of $2.7 billion, driven by freight rate increases and a 3% increase in carloadings. Railroads are able to raise shipping costs without much resistance.

ConclusionIf the economy continues to chug ahead for the next few years -- even at the lackluster rate of 2% GDP -- railroads will continue to grow their earnings. Smart investors need to get on board and invest in the rails. Railroads are about three times more fuel-efficient than trucking, so they have a long and secure future.

Warren Buffett was not the first to invest in the growing American rail play, but his bet on BNSF Railway really paid off. I believe Union Pacific, Canadian National and Kansas City Southern offer tremendous long-term growth potential -- and that Union Pacific has the most attractive valuation.